Monday, May 05, 2008

Pilgrimage Concluded: “This is a Rational Place”

Note: Originally published June 26, 2007.

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Scary-Smart, With Visions of Fatness

I always thought Warren Buffett was irreplaceable.

He seemed to be a genetic mutation of sorts—not merely a smart, self-confident, and supremely logical thinker who’d cornered the market on value-based investing, but a man with a preternatural ability to do precisely what he and his partner, Charlie Munger, seek of his eventual successor at the helm of Berkshire-Hathaway:

“We’re looking for someone who doesn’t only learn from things that have happened, but can also envision things that have never happened.”That's how Buffett put it during the question and answer session of this year's Berkshire-Hathaway shareholder meeting, when asked about the search to replace the seemingly irreplaceable “Oracle of Omaha.”

“Many people are very smart, but they’re not wired to think about things that haven’t happened before.”

And it was precisely Buffett’s apparent ability to see the unforeseen that had caused me to finally get on a plane bound for Omaha—after years of reading his annual shareholder letters and studying the shareholder meeting transcripts that, before the internet came along, were passed like samizdat among the growing legions of Berkshire followers—to see the irreplaceable Buffett in the flesh.

I wanted to witness the Berkshire-Hathaway phenomenon just once, before his mystical powers had diminished—or worse—and the company’s leadership had passed to younger, lesser individuals.

And I’m glad I did it...manual-locking rental car and shirtless-shareholder-in-the-parking-lot notwithstanding.

My own personal apprehension of Warren Buffet’s apparent clairvoyance came nearly thirty years ago, almost the very first day I started on Wall Street.

It was 1979, not long after the Iranian revolution had triggered the second great oil shock in a decade, and I’d been hired out of college by a major Wall Street firm to be an oil analyst, albeit an extremely junior one. It was lucky timing on my part, since oil prices had recently tripled and, for reasons that now escape me, were widely expected to hit $100 a barrel in another year or two.

Practically from the day I started all anybody on Wall Street wanted to hear about was oil and oil stocks—even if the person doing the talking was an extremely junior analyst who knew next to nothing about the real world, let alone investing in general and oil stocks in particular.Strangers asked for tips on the elevator, and I gave them. It was quite the heady experience.

Meanwhile, a heretofore successful investor out of Omaha, Nebraska had begun accumulating a large position in General Foods, the predecessor of today’s Kraft Foods and owner of such stalwart brands as Maxwell House, Birdseye, Post and Kool-Aid.

Hard as it is to imagine now, packaged food companies back then were considered slow-growing, dull businesses—victims of a decade's worth of oil shocks and wage-and-price controls. Their stocks were for value-investing chumps and coupon-clipping widows and orphans, not performance-hungry fund managers.

Given Wall Street’s infatuation with oil stocks, few people outside his then-small band of loyal followers could understand Warren Buffett’s infatuation with General Foods.Indeed, by the time Berkshire-Hathaway had accumulated 9% of that company’s shares in a stock market that was only too glad to sell, the question around Wall Street had changed from the initial, curious “What is Buffett thinking?” to the jaded, cynical “What is Buffett thinking?”

What Buffett was thinking, I learned by reading those shareholder meeting transcripts, was “shelf space.”

General Foods’ key asset, he explained, was the supermarket shelf space commanded by its brands—Maxwell House coffee, Birdseye frozen foods and Post cereals, not to mention Kool-Aid. Since no supermarket could do without ‘em, General Foods was able to price those products high enough to earn a superior return on investment, even in an inflationary cost environment, with everybody expecting oil to go to $100 a barrel.

Of course, oil never went to $100 a barrel. It never even got to $50 at that time.

It stopped instead at about $35, because something happened that our spreadsheets—Wall Street research departments were among the first to get a new invention, the “personal computer,” which enabled us to construct wonderfully complex and totally meaningless five-year earnings forecasts—hadn’t taken into account: demand for oil dropped.

In fact, it collapsed.

And as demand collapsed, so did oil prices (eventually down to $10 a barrel). Things stopped going against packaged food companies and started going for them. With costs declining and demand rising, General Foods made a killing, thanks to all that shelf space.

By the time Wall Street got around to realizing the inherent value of “shelf space”—and people had stopped talking to me on the elevator except to tell me which floor button to push—General Foods had been acquired by Phillip Morris, to the enormous benefit of Berkshire-Hathaway’s balance sheet, Warren Buffett’s reputation, and his growing base of worshipful shareholders.

While, in retrospect, buying stock in the country’s largest packaged foods company on the cusp of the greatest consumer spending boom since World War II looks like a “no-brainer,” it was, at the time, not at all obvious.

In fact, it was entirely contrary to the previous decade’s worth of learned investment behavior. To buy General Foods in the late 1970s and early 1980s, as Buffett did, was to “envision things that have never happened.”

I began to understand why people called him the Oracle of Omaha.

Yet Buffett was no clairvoyant. He had not predicted the future. He had not foreseen the oil price collapse. He had not divined the takeover by Phillip Morris. He had not even bothered working up a five year earnings forecast on one of those new-age “personal computers.”

What he had done was much simpler, but at the same time far harder: he had correctly identified the key asset of a company, measured its worth, and judged it vastly under-priced in a stock market still looking backward at recent history, rather than forward at things that hadn’t yet happened.

The result was such a clear investment opportunity that Buffet had no need to precisely calculate the exact value of those General Food brands or to worry about how quickly he would get paid for owning 9% of their “shelf space.”

As Buffett himself said at this year’s meeting, when asked his opinion of hurdle rates and such manner of sophisticated valuation techniques,

Yet it wasn’t until after I’d taken my seat at the Qwest Center and observed Buffett answer question after question—over thirty in the course of nearly six hours—with the firmness, confidence and constancy of a minister who has been preaching the same gospel for half a century, with only subtle adjustments to the canon, that I really grasped the full import of that central fact.

Charlie Munger corroborated the inexact nature of the Buffett method this way:

“We have no system for estimating the correct value of all businesses. We put almost all in the ‘too hard’ pile and sift through a few easy ones.”

Thus, the heart of Berkshire-Hathaway’s success is not solely the prodigious brainpower of a unique human being, it is a rational process immune to current waves of thought.As Munger later summed it up, with characteristically profound simplicity,

“This is a very rational place.”

And since what needs replacing at the head of Berkshire-Hathaway is the extraordinarily rational behavior of an extraordinary human being, not the mystical powers of a genetic mutation, I have come to the conclusion that Warren Buffett is, in fact, replaceable.

Charlie Munger, too.

Furthermore, although the general sense on Wall Street is that, as Buffett goes, so goes Berkshire-Hathaway, Buffett and Munger will almost certainly find a capable succesor, for the two men are, not surprisingly, taking an exceedingly rational approach to the search process:

“We want to give them [several people] each a chunk of about $5 billion and have them manage it over time, as if they’re managing $100 billion. Then we’ll turn it over… We’re not looking for someone to teach, we’re looking for someone who knows how to do it.”

This is not to say “Uncle Warren,” as he is called by some of the longer-term members of the faithful, won’t be missed in his role as the colorful master of ceremonies at these annual meetings.

And it is hard to imagine anyone but Charlie Munger playing the urbane, Dean Martin-ish straight-man to Buffett’s more animated, wise-cracking Jerry Lewis. (Munger: “I don’t know anything about it.” Buffett: “Neither do I, I just took longer to say it.”)

Nor do I mean to understate the unique abilities both men possess.

First and foremost, Warren Buffet is scary-smart.This should be obvious, but it’s easy to lose sight of, especially when the avuncular, self-deprecating “Uncle Warren” discusses both his successes—which he generally ascribes to Munger’s wise counsel or the “All-Stars” who manage the various Berkshire-Hathaway businesses—and his failures, for which he takes all the blame.

“I bought too early and I sold too early. Other than that, it was a perfect trade.”Later, he again took full responsibility when reminding his audience of Berkshire’s disastrous investment in US Air:

“I bought into a high-cost airline [US Air] thinking it was protected…but that was before Southwest [Airlines] showed up….”

Now, in the course of this brief, self-flagellating airline discussion, Buffett happened to toss off two obscure numbers: the cost-per-seat-mile of fanatically efficient Southwest Airlines (“8 cents”), and the cost-per-seat-mile of the aging, inefficient US Air (“12 cents”).

And it is no coincidence that cost-per-seat-mile is the single most important variable in the airline industry. For during the course of the day, Buffett invariably zeroed in on the most important number for whatever industry came up.

Whether it was the current circulation of the Los Angeles Times, which Buffett pegged at 800,000 during a discussion of the newspaper industry’s current problems (and which I later discovered is, in fact, precisely 815,723), or the finding costs of a particular oil company whose annual report he and Charlie had read recently, Buffett knows what to look for:

“There was no discussion of finding costs in the [CEO's] letter…” he said indignantly of the oil company report, “…because of course it was a terrible figure.”

As one who started life on Wall Street as an oil analyst, I can say that “finding costs”—the money an oil company spends to discover and develop its oil reserves—is hands down the single most important indicator of an oil company’s long-term value. It beats revenues, margins, reserves, and anything else you can think of.

And, despite the fact that less than 3% of Berkshire-Hathaway's $65 billion portfolio is in U.S. oil stocks, and only one at that (Conoco Phillips), Buffett knows exactly what he's looking for when he reads their annual reports.

Thus it is that whether he’s talking about food companies or airlines or newspapers or oil companies, Buffet has clearly made it his business to identify the single most important variable for each business—and knowing those crucial variables, he can determine whether the values offered in the stock market at any given time are attractive, or not.Without using a spreadsheet.

Still, it is not enough that Buffett himself is scary-smart: there is a reason Charlie Munger is his partner, confidant, and closest advisor.While Munger does occasionally lapse into grumpy-old-man syndrome—he dismissed the potentially catastrophic impact of global warming by quipping “It would be more comfortable if the world was a little warmer,” and his mail-order-bride-with-AIDS crack went over like a lead balloon—he is every bit Buffett’s peer in the realm of the mind.

It is probably no coincidence that one of Berkshire-Hathaway’s least profitable investments was the aforementioned silver trade, which in fact was Buffett's idea alone.

Yet it is not merely being scary-smart, and partnering with a like-minded individual to help him keep the place "rational," that has caused Buffett to make Berkshire-Hathaway a market-beating, efficient-market theory-confounding enterprise for nearly forty years.

Being in Omaha has something to do with it too, I think.

For Omaha sits smack in the middle of the country, both geographically and metaphorically. Even with jet travel, it is not all that easy to get to for anybody, let alone an eager young investment banker trying to push a bad deal, or an extremely junior analyst passing off third-rate stock tips.

The buildings are mostly solid brick and granite: insurance companies, not investment banks, dominate what skyline there is. The streets are wide and quiet. Even the river flows relatively undisturbed, allowed to flood its banks in places.

In this quiet environment it is no wonder, I think, that the following is how Buffett described his and Charlie’s frenetic activity during the 1998 worldwide financial panic:

“We knew during the Long Term Capital Management Crisis that there would be a lot of opportunities, so we just had to read and think eight to ten hours a day.”

I can tell you that not very many people on Wall Street—or in any other financial capitol around the world—were “reading and thinking” during those fear-crazed days when a highly leveraged hedge fund nearly brought down the system.

Being thus removed from what he calls the “electronic herd,” Buffett can ignore the short-term distractions of Wall Street, and focus on the long term opportunities for his shareholders.And by "long term" I don't mean one year or even three years:

“You need to see five to ten years out,” he told his shareholders at one point.

And those shareholders are willing to wait. After all, they have been waiting—some for as long as forty years—and they have been amply rewarded for doing so.

Being in Omaha, and having perhaps the most patient shareholder base in the world, allows Buffett to wait, and eventually act, on those visions of fatness.

Now, Warren Buffett isn’t above a little self-promotion.

That movie at the start of the morning session was nothing if not a panegyric to Warren Buffett. And he is, I am told by reporters who have dealt with him over the years, surprisingly accessible, particularly when the story in progress is not necessarily flattering, as during the AIG-General Re "finite insurance" flap of a few years back.Furthermore, he’s a proven master at setting low expectations—something many of today’s CEOs attempt to do so that Wall Street analysts will be pleasantly, if artificially, "surprised" with the actual results:

“When you see last year’s [insurance profit],” Buffett had cautioned early in the meeting while reviewing the Berkshire-Hathaway earnings report, “look at it as an offset to future losses.”

And when Charlie Munger later warned shareholders, “We won’t make the kind of returns on these [new investments] we made on investments 10-15 years ago,” Buffett immediately chimed in: “We won’t come close.”

Of course, both Buffett and Munger have been saying these kinds of things for ten or fifteen years, at least, and their shareholders know enough to expect more, because unlike the typical Fortune-500 CEO who attempts to raise his stock’s value by setting artificially low expectations and beating them modestly in the short-run, Buffett and Munger have been exceeding their shareholders’ expectations for decades.

It is early Sunday morning, the day after the shareholder meeting and our trip to the Nebraska Furniture Mart.

Outside it is still dark and raining. The storm clouds that had opened on our way to dinner last night were part of a heavy weather system that spawned tornadoes in Nebraska and other parts of the Midwest over night. One destroyed an entire town in Kansas, I find out after turning on the Weather Channel.Getting home is looking tricky.

Instead of waiting for the lackadaisical hotel shuttle, I split a cab to the airport with a man who does not appear to be a member of the Berkshire-Hathaway shareholder crowd. While most of the people we saw at the Qwest Center yesterday were older, paunchy, and quite relaxed, this guy is young, fit, and quite impatient to get to the airport.

Turns out he works for Warren Buffett.

As we talk, I discover he’s with an insurance business acquired by Berkshire-Hathaway in the recent past. And while he had only first met Buffett the night before at an insurance dinner following the shareholder meeting, he knows quite a bit about Ajit Jain, Buffet’s ace “super-cat” insurance man.

Jain handles the so-called super-catastrophic insurance policies that Berkshire-Hathaway makes a specialty of underwriting, at great profit. Mike Tyson’s life, billion-dollar Pepsi contests, earthquakes and town-destroying tornados are the stuff of Ajit Jain’s territory, and he is a legend in the business, thanks in part to Buffett’s frequent mentions in the shareholder letters, as well as his reputation as the insurer of last resort.

I ask my fellow cab-rider his impression of Jain, and he gives me the two-word answer you might have expected by now:

“Scary-smart.”

Then he shakes his head. “Ajit never writes anything down. But he remembers every number you ever gave him.”

He could, of course, be describing Warren Buffett.

The trip to the airport is brief so our conversation ends quickly. He leaves for his flight, and I for mine. The sky lightens as the sun rises, and the rain mutes to a drizzle. My flight leaves on time, lifting off over the muddy river and the brown, flooded fields, up into the clouds. The trip home is smooth and without incident.

Berkshire-Hathaway without Warren Buffett will not be the same company, but that is not saying anything nobody didn't already know. Furthermore, the great investment returns of yesteryear will diminish with or without him—the law of large numbers will see to that.

I also suspect Buffett’s successor will find that the Berkshire stable of businesses—at least those outside the core insurance operations, such as Fruit of the Loom, See’s Candies and especially Nebraska Furniture Mart, from which Buffett has been draining much cash over the years—would do better over the long term as publicly traded companies in their own right.

But as Charlie Munger told shareholders, “Berkshire has a very strong culture that will continue after we are gone.”And whatever scary-smart individual they find who fits that culture should do okay, so long as he or she maintains the key strengths of Berkshire-Hathaway, which Buffett neatly summed up near the end of the day:

“We have good businesses, deal from strength, always have a loaded gun, and have the right managers and people and an owner-oriented culture.”

But whoever replaces Warren Buffett will need one more thing:

They'll need a Munger, to keep the place rational.

The End

Author's Note:This rumination on the Berkshire-Hathaway annual meeting would not have been possible without the following:

The readers of this blog, whose patience and encouraging feedback prompted a much fuller contemplation of the Berkshire-Hathaway annual meeting than I ever intended—to my own benefit, if not their own.

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews' recommendations. This commentary in no way constitutes a solicitation of business or investment advice. It is intended solely for the entertainment of the reader, and the author.

An outstanding series of commentaries on two icons of the financial world. I feel very fortunate to have read this series and when time allows, I will read this entire series a second time. Thanks so much Jeff for all the time and effort you spent on sharing your observations and thoughts on the annual Berkshire meeting.

Jeff - many thanks. Like you I've been a follower of Buffett and his letters for a while, though not as long as you and found them some of the best investment and business thinking ever. Your Omaha report goes beyond that in providing a much deeper insight into the processes, attitudes and skills - that is we can sorta get a glimpse of the process instead of just the results and descriptions thereunto.

This last post raises a couple of fascinating questions - how well do you have to understand a company and industry to know what the "one number" is ?

And doesn't that suggest that understanding how a particular business works and the implications for the long-term are the ultimate path to understanding and capturing value ?

In other words shouldn't we, as investors, employees or other stakeholders be bending every effort to developing that capability ourselves ?

A couple of his larger 1990s deals (KO, G) notwithstanding, Buffett seems destined to be forever searching for places to invest surplus cash due to his aversion to paying for growth. He must realize that he could save tons of time and reinvestment effort with more big growth names and fewer Acme Bricks.

Given his recent comments regarding his personal income tax rate vs. his secretary's, and his longer history of complaining about tax cuts, etc, I'm curious to know if Buffett spoke out at all about taxes, corporate or personal, during this session.

This really was a pleasure to read. Like you and a lot of the others I have read and enjoyed both the the Berkshire letters and AGM transcripts, this however, was the closest thing I have read to being there. You should consider a career as a financial travel writer, a Bill Bryson of the AGM as it were. Thanks for all the time and effort you put in. One last point. I know "Uncle Warren" has complained about the "helpers" and the "2 and 20 crowd". Do you or anyone out there know what the Buffett Partnership charged?